William Isaac is Wrong on Market Value Accounting

David Henderson quotes Isaac to the effect that we would have had thousands of bank failures under market value accounting in the 1980's. That is wrong. If market value accounting had been in place in the 1970's, we would not have had a banking crisis. The first banks to get into trouble would have been shut down in a timely fashion much sooner, and the rest would have taken steps to protect their franchises. It was because we did not have market value accounting that so many banks and savings and loans took excessive risks that were borne by the taxpayer.

Historical-value accounting was an invitation to bankers to loot. Of course, what we are seeing today is that looting is encouraged by the political process in general. After all, it's not the politicians' money that is being looted. See this post (or almost any post) by Simon Johnson.

> OK, why? You can obviously have any sort of value accounting scheme without the looting of taxpayers.

If I understand, it is because with historical-value accounting, players make absolutely no claim about future returns, and so the players can take on all kinds of business that no one can defend as being sustainable, as that business grows and grows and grows.

The usual analogy is jumping off of a 50 story building. When you reach floor 20, you have 30 stories, historically, of fine results. But nobody could defend your continued descent as sustainable.

The politically enabled players take on all kinds of business, for short-term gain, then walk away before the inevitable crash, for the taxpayers to pay far, far above the total sum of the payday of the players.

If the players have to defend a future value to the marketplace, they have _some_ responsibility to demonstrate sustainability, as they take on more and more and more business.

What leads to looting of taxpayers is: (1) not having to defend *any* reasonable story about future returns (2) politically enabled players taking a short term payday on a huge amount of unsustainable business (3) with the players knowing somebody else will pay for the ultimate massive shortfall, a shortfall much more massive that the monies actually looted.

If market value accounting had been in place in the 1970's, we would not have had a banking crisis.

Isaac was head of FDIC in the early 80s, so I'm assuming he's referring to the problems of Volcker's slamming money growth in 1981-82. I'm trying to think of how MtoM would have stopped the Fed's irresponsible policy of the 70s.

It seems to me that MtoM would have contributed to making things worse, because durable assets and real estate were actually appreciating against the depreciating money. So, they'd have been marked UP.

"If I understand, it is because with historical-value accounting, players make absolutely no claim about future returns, and so the players can take on all kinds of business that no one can defend as being sustainable, as that business grows and grows and grows."

Right, but make banks defend this to investors, not regulators. So if we should make Mark to market a requirement for banks to disclose to investors looking to put in capital, but not for capital requirement ratios.

This is exactly as I understand Henderson's and Buffet's argument posted earlier.

The problem with mark-to-market as I understand it (I do not have any special expertise in this area) is that the lack of a real market and the difficulty of knowing what is behind the cash flows makes it easy for the price to drop based only on rumors and uncertainty. I heard of one case where the "market" value of one of these assets was 14 cents on the dollar while the cash flow was still coming in at 100 percent. When banks can have what appears to be solid assets one week and the next they have dropped to some unknown value close to zero, it does the same thing as a run on the bank even though no money is withdrawn. To make matters worse, it affects every bank in the world, not just the weak banks that are rumored to be in trouble.

If a bank is holding the mortgage on my house and I lose my job yet am able to continue making my mortgage payments, the bank does not mark my loan down. Why, then, if a securitized mortgage derivitive is continuing to pay its full cash flow would the bank need to write down the value based on rumors. I like the idea of valuing mortgage assets based on cash flow performance and use mark-to-market as disclosure information but not as the value of the asset. If the cash flow drops due to non-payment of mortgages the value can be marked down at that time beased on reality and not rumor. This will not cause looting, but it will prevent some crazed treasury secretary from destroying the value of our entire financial system with ill timed predictions of doom.

> Right, but make banks defend this to investors, not regulators. So if we should make Mark to market a requirement for banks to disclose to investors looking to put in capital, but not for capital requirement ratios.

Mark-to-market requirements can have different objectives. If one of the objectives is preventing the looting of taxpayers, then we are most definitely talking about capital requirement ratios.

Because, as we are currently experiencing, the buck stops with the taxpayer. Investors in banks have no ultimate responsibility to pay for all bank shortfalls; the worst that can happen is the complete devaluation of their investment, which in this case is small compared to the loss.

John Hempton (former Australian Treasury official, now an investor) has the most clear analysis of bank solvency I've seen. He points out there are 5 different measures that matter: Regulatory Solvency, Positive net worth under GAAP, Positive economic value of an operating entity, Positive liquidation value, Liquidity.

There's no one simple right answer on "mark to market", you want to use it for some of these, not others.

His blog is full of interesting observations, including lots of disagreement with Krugman (for those who like that) and outrage over how the government mishandled Washington Mutual

"the most capricious government action of this cycle and possibly the worst thing that has happened to American Capitalism this cycle ... It changed the order of creditors and the basis on which banks all across America raise wholesale funds... without appeal, without due process and without accountability.... In the process the OTS and the FDIC have effectively removed the main low-cost source of funds of pretty well all banks in America ...it spells doom for any bank in America that is ultimately reliant senior (and hence well protected) but unsecured financing..."

... all of which worked out pretty much like he predicted.

And how can you not enjoy a guy who uses the price of hookers to predict national financial crises (accurately!)?

"Right, but make banks defend this to investors, not regulators. So if we should make Mark to market a requirement for banks to disclose to investors looking to put in capital, but not for capital requirement ratios."

How do we differentiate between the two? What is a general depositor in a bank to be classified as? The FDIC backs his money and the FDIC is implicitly backed by the taxpayer. Regulators are supposed to be responsible to the public, and the public is continuing to back these organizations through bailouts and the federal reserve and the FDIC. The only reason they shouldn't be counted (the public) as investors is that their upside is just not losing to much instead of gaining.

I think you're confusing depositor with a stock investor. Depositors are provided the service of keeping money and gaining interest while the bank lends out a certain percentage for its own profit (hence, intermediating between those who wish to hold cash and those who wish to borrow it). You are correct that the government is becoming a major investor in our financial system to try to keep it afloat, but my point is regarding individual investors buying a portion of the bank deserve to know what the market thinks its assets are valued at. If we change the definition for regulatory solvency, than more banks will become regulatory solvent; that's all I'm saying. Banks that achieve regulatory solvency will behave as though they are fully solvent, which may loosen credit markets.

I've been thinking this argument over for the past few days, and I've come around to the pro-mark to market side of things a bit. Basically, I think they would argue that we might as well just suffer through the pains of badly issued assets now, as they will just under perform in the future and cause us the same pain but be less transparent. I also missed a key point, Warren Buffet wants to end mark to market from the view of investors as well to boost their stock price which will help them raise capital faster.

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